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Updated Dec. 16, 2008 12:01 a.m. ET

TO ZERO AND BEYOND!

In an historic decision, the Federal Open Market Committee said it would peg the federal funds rate at between zero and 0.25% and, having effectively run out of basis points in the overnight rate, will seek to boost its purchases of longer-term securities to lower their yields.

In effect, the U.S. central bank has adopted the former strategies of the Bank of Japan to battle deflation: a zero-interest-rate policy, or ZIRP, and quantitative easing, or QE, in which the Fed expands its own balance sheet to increase the supply of money and credit.

The FOMC said it these unprecedented moves came as "labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined" since the panel's previous meeting in mid-October.

"Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters," the panel also said in its policy statement.

"They did not save any rates ammunition, and they committed to provide even more massive firepower via quantitative easing. The Fed has been confronting with an 'irresistible force' in the form of historic financial and economic deleveraging/deflation. They are providing an 'immovable object' of fiat government resolve to stop deleveraging/deflation," he adds.

Stocks, Treasuries and gold rallied in response to the Fed's moves, the Dow Jones Industrial Average the Dow Jones Industrial Average closed up 360 points, or 4.2%, at 8924. Treasury yields fell to new lows, with the benchmark 10-year note dropping to 2.26% while the 30-year bond ended at 2.72%. At the short end, the two-year note ended at 0.65 while the five-year note yielded just 1.29%. Nearby Comex gold futures advanced to just over $850 an ounce from $839.90 just before the FOMC announcement.

The Fed mainly formalized what have been de facto near-zero rates on fed funds despite the official 1% target. Moreover, the key three-month London interbank offered rate, or Libor, has moved steadily lower. This benchmark money-market rate is down to 1.80%, still well above the actual overnight rate, but far below its peak of 4.80% at the worst of the credit-market crisis two months ago.

With overnight rates at a mere fraction of a percent already, the effect of the Fed's move on the funds rate mainly is symbolic. To be sure, symbolism is important as the focus of Chairman Ben Bernanke and his colleagues "will be to support the functioning of the financial markets and stimulate the economy."

More substantively, the Fed is seeking to bring down longer-term rates, especially mortgage rates. It noted that, as previously announced, it "will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant." Yields on Fannie Mae and Freddie Mac MBS plunged in response, ending below 4% for the first time.

That should help push rates on 30-year conforming loans -- the kind that mortgage agencies Fannie Mae and Freddie Mac can purchase -- down toward 5%, from 5.53% currently, according to BankRate.com But other non-conforming loans, remain far higher -- higher even than before the Fed started easing policy over a year ago. For instance, prime jumbo 30-mortgages, still cost over 7%. So, these moves are not panaceas for the housing market.

To push longer-term interest rates lower, the FOMC also said it is also "evaluating the potential benefits of purchasing longer-term Treasury securities." While that might be supportive of lower conforming mortgage rates, it remains to be seen if it will lower corporate bond yields, which stand at a record margin over Treasury securities.

As another avenue to channel credit to private sector, the Fed also said it would implement another mechanism, the Term Asset-Backed Securities Loan Facility, which should help get loans to households and small businesses. The central bank added it "will continue to consider ways of using its balance sheet to further support credit markets and economic activity."

The bottom line is that this is biggest change in the conduct of U.S. monetary policy since 1979, when the Volcker-led abandoned targeting of the fed-funds rate and concentrated on restricting bank reserves to kill double-digit inflation.

With the fed funds rate effectively at zero, the Bernanke Fed has embarked on expanding the central bank's balance sheet to combat deflation and recession. For now, inflation pressures are nil, as highlighted by the record 1.7% decline in November's consumer price index reported Tuesday.

The trick, notes Joan McCullough of East Shore Partners, will be for the Fed to drain the massive liquidity it has created once recovery begins to take hold. The Greenspan Fed was slow to bring the funds rate up from 1% starting in 2004, which inflated the real-estate bubble, the bursting of which has led to the debt deflation policymakers are grappling with now.

That concern, while valid, remains for the future. For the moment, the Fed has thrown all its firepower at combating the current crisis.